Cryptocurrencies, in general, have received plenty of media attention in recent months. They have started a revolution in global finance, and have turned investors into billionaires overnight. Many people don’t realize, however, that cryptocurrencies are also disrupting the venture capital industry as well. Through a process known as an ICO, fledgling businesses are raising billions of dollars in startup capital and operating funds almost overnight.
If you’ve never heard the term, an ICO, or Initial Coin Offering, is the process by which a startup creates and then distributes a new cryptocurrency as a means of funding their company. ICOs are rapidly becoming an attractive and viable alternative to the traditional venture capital process for many tech-based companies. For the uninitiated, here’s a guide that will fully explain the process, and answer the all-important question – what is ICO?
The ICO process
In the past, when a startup sought to find investors to buy into their vision and back it up with cold, hard, cash, they’d usually turn to large banks and venture capital firms. Those institutions offer to fund to startups that have already demonstrated growth in exchange for an equity stake in the business. The problem that technology startups often face is that they need access to significant funding to develop their products – and won’t begin to grow until they get it. For them, an ICO fits the bill perfectly.
To begin an ICO, a startup typically creates a plan or whitepaper that spells out exactly what technology they are trying to create, what purpose it serves, and how much money they need to make it a reality. Then, they create a cryptocurrency and announce how many tokens will be made available to the public, and how many will be retained by the company. The earliest buyers during the sale period are often rewarded with a discount on the cost of each token, making a better return on investment more likely.
The risks involved
An ICO is a great way for innovative new businesses to secure financing for their ideas, but they are not without risks, both the to company organizing the ICO and to investors. For the startup, the ICO must reach its initial sale goals, or all of the collected funds are returned to the token purchasers. If that happens, it means that the startup will have spent all of the money necessary to organize and promote the sale, but with no results to show for it. A startup facing that kind of loss is doomed to fail.
For investors, though, the risks of an ICO are far, far, greater. First, the ICO market as it exists today is largely unregulated, leaving investors at higher risk of fraud and other malfeasance. To illustrate the danger, the U.S. Securities and Exchange Commission went as far as setting up their own fraudulent ICO website to educate neophyte investors. They’ve also stepped up prosecutions of anyone caught trying to steal investor funds through an ICO.
Managing the risks and avoiding scams
For investors, an ICO can be an excellent chance to get in on the ground floor of a technology company with a bright future. As previously mentioned, though, they can also be a way for scammers to lure victims into a trap. To avoid an ICO scam, investors should look for these telltale signs of trouble:
- Unknown Founders and Staff – While some startups are launched by relative unknowns in the cryptocurrency industry, there’s a good chance that anyone involved in a legitimate ICO has a well-established digital footprint. Always research the history of the major players behind an ICO before investing in it.
- Promises of Huge Profits – Like any other kind of startup venture, a company that organizes an ICO has a chance of failure. An honest business would admit as much. If an ICO is trumpeting how much money investors will make through the coins they’re selling, buyer beware.
- Unrealistic or Unnecessary Goals – When evaluating an ICO to determine the legitimacy of the offering, the first thing to look at is the product the company is aiming to create. Many ICO scams rely on industry hype to pitch products that don’t make sense when scrutinized. If the technology on offer doesn’t seem like it solves a real-world problem, you might be looking at a fraudulent ICO.
- Non-Public Code – Any real technology company organizing an ICO should be making the blockchain code behind their efforts available on a code repository like Github. If it isn’t available, or if it isn’t being updated on a regular basis, it could be a scam. The publically available code allows third-party auditors to make sure that the ICO is fair, safe, and legitimate.
Despite the risks, the ICO market has had a number of success stories that have spawned successful companies and happy investors. The most visible example is Ethereum, which is now the second-largest cryptocurrency by market capitalization in the world. During Ethereum’s ICO, Ether tokens sold for a mere $0.31. At the time of this writing, they’re worth about $518. That represents a 167,000% return on investment. That kind of appreciation in value is unheard of for almost any other type of investment, which is why the ICO market has remained robust, despite the challenges of fraud and looming regulation.
The bottom line
ICOs, like cryptocurrencies themselves, aren’t going away any time soon. As long as innovative entrepreneurs keep dreaming up new technologies and turning to an ICO to fund their enterprises, investors will continue to flock to the market. As previously noted though, the world of ICOs presents a high-risk high-reward proposition for investors, who have to use their own best judgment to avoid major losses. Those that do still can realize returns that outpace any other kind of investment. As global regulatory bodies continue to work to police the ICO marketplace, it should mature into a stable, safe, and mainstream financing vehicle for the global industry. For ICOs, the sky is the limit.